procurement management report

8/2/2019 Procurement Management Report

1/35

Special Report

The ImporTanceof

procuremenTInaGlobal envIronmenT

The second in a series of special reports on operations in business

http://www.bcg.com http://knowledge.wharton.upenn.edu


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Contents

The Importance of Procurement in a Global EnvironmentUntil recently, procurement was a necessary, but seldom celebrated, component of mul-

tinational corporations. But times have changed: These days, procurement organizations

within companies are playing pivotal roles in the success of global firms in ways that

old-fashioned purchasing managers could never have imagined. In this special report,

Wharton faculty and procurement experts at The Boston Consulting Group discuss whythe procurement function has risen to such prominence in a highly competitive global

environment, and how, as supplies of critical commodities tighten and prices rise, com-

panies can strategize to mitigate these and other risks.

Procurement The Strategic Perspective 1

Challenges Facing Procurement Organizations 4

Global Supply Chain Strategy 8

Building Customer-supplier Relationships 13

Sourcing from China 17

Subcontracting and Product Quality in China 21

Managing Commodity Risk 25

Performance-based Logistics 29


3/35The Importance of Procurement in a Global Environment

Procurement has taken on greaterstrategic importance in multinational companies

in recent years and it will assume even greater

significance in the years to come, according to Hal

Sirkin, senior partner and managing director at

The Boston Consulting Group and global leader

of BCGs operations practice. In an interview withKnowledge@Wharton, Sirkin discusses procurement

in the context of global business, and the ways

in which companies from rapidly developing

economies are challenging traditional multinationals.

Knowledge@Wharton:Companies have beensourcing from China and other low-cost locations

for years now. What level of expertise and cost

savings are you seeing?

Sirkin:Weve seen cost savings in the range of 20%to 40%, depending on what the product is. On the

other hand, weve also seen examples where there

were no cost savings when companies tried it.

There are a lot of advantages to going to low-cost

countries to source, but it has to be done right. I

think the biggest mistake that companies make is

that they try to source things and forget it and

you cant forget it.

There are really three things that you have to get

right: the product, the process, and the location.

First, you have to think about what the product

is. Are you sourcing the right part or the right

product? That really means that the company yourebuying from needs to have the technical capability

to produce it well and the practical capability to

execute it well. But you also need to see if it even

makes sense to source it from China or other

low-cost locations. If a part requires 50% labor, it

makes a lot of sense to go to countries that have

low-cost for labor. But if it only has 10% labor

content, then it makes more sense to buy closer to

home and save on the transportation costs.

The second thing is having the right process with

regard to the supply chain and quality. From a

supply chain perspective, you have to make sure

that the costs dont eat up the savings. So, items

that are difficult to transfer such as large, bulky

or perishable products become an issue. Or, if

you have a fashion product or something with a lot

of variable demand, sourcing it far away means that

youll have to hold a lot more inventory. That means

higher costs and a greater risk of obsolescence.

Weve seen people trying to offshore and outsource

parts and products with 300% variation in demand,

and when that happens, the value goes down.

In addition to the right supply chain, you have tohave a quality process in place. Now, weve seen a

lot of examples recently where companies have had

problems with the quality of the products that are

coming in. Some products were unsafe and others

were unusable. Whenever you outsource, you have

to invest your time and people to make sure that the

quality process is in place, because your brand is

on that product, whether you make it in Chicago or

Procurement The Strategic Perspective

There are a lot of advantages to

going to low-cost countries to source,

but it has to be done right. I think thebiggest mistake that companies make

is that they try to source things and

forget it and you cant forget it.Hal Sirkin, senior partner and

managing director, BCG


4/35Boston Consulting Group | Knowledge@Wharton Special Report

2

Sirkin:Three things come to mind. One is to rethinkwhat you do. Again, if you move to an environment

with a much lower labor cost, you need to think

about things differently. Fundamentality, there is

what we call the capital/labor trade-off. If youre

in an environment of $25- or $50-an-hour wages

fully loaded, you think about the trade-off between

capital and labor very differently than if youre in an

environment like China where wages are $1 to $2 a

hour.

At that point in time, you may say, I want to

produce things. I dont want to spend as much

money on capital assets because wages are so low

I want to think about how to set up my factory, but

also want to think about the design of my product.

I want to avoid high-cost labor, Ill design a simpler

product with fewer screws and other small parts,

something that can be made with an automated

production process. But if wages are only about 4%

of what I would pay in the West, the capital/labor

trade-off is different. I may design a product with amuch more manual production process with things

like screws rather than more fancy welding because

its fundamentality cheaper.

Many automotive factories fall into this trap. U.S.

and European companies copied their plants and

then sent them to China. In doing so, they actually

ended up with a higher cost position, because they

put in lots of automation and they were sub-scale.

To succeed at low-cost sourcing, companies first

need to rethink what they do.

Second, they need to rethink the whole opportunityand that doesnt mean just sourcing. If youre going

to produce in China and India where there is a

combined population of about 2.5 billion people

you may want to think about using your production

facilities as a platform to start selling in those

markets or expanding sales in those markets. Or

[you may want to] use your plants for more than jus

that single part or that single product or that single

division of your company. Use them as a lever to do

even more sourcing there for the right products.

Third and this is the most controversial [and]people worry about it tremendously you have to

find ways to protect your intellectual property. You

need to be explicit about the trade-off between the

cost savings and the risk of losing your intellectual

property and make some real decisions. Weve seen

companies lose intellectual products because they

sent them to countries with lower protection.

2

China. And because your brand is on that product,

you have to make sure that you defend it and

whatever you produce. Saying that it was Made

in China or Made in India does not defend you

against a quality problem. In fact, it may make it

worse in the publics mind.

The third thing is to outsource to the right location.

The absolute lowest direct cost is not always the

best thing to do. Back to supply chain issues, ifyoure thinking about bringing something to China,

youll also probably if youre in the U.S. want

to consider Mexico. Or if youre in Western Europe,

youll want to consider Eastern Europe because

you may have a much better balance there [even

though the direct cost may be higher] of avoiding

supply chain problems, such as large variability and

inventories, and the hidden costs of other things.

In the U.S., with increasing port constraints, we may

be seeing delays over time. And Mexico, which of

course does not require importing through ports,

may be a good alternative. So, get it right [and] you

can see a lot of savings. Get it wrong and your costs

actually go up.

Knowledge@Wharton: So then, would you say that

the level of expertise that you are seeing amongst

the companies that are sourcing globally is pretty

good or do they have a way to go?

Sirkin: Well, some companies do it well. Theyve got

a lot of experience and their expertise is extremely

good. They avoid a lot of the problems and they

are making the right decisions. Other companies,normally the ones that are starting, are going in

sometimes way too fast without the right level of

expertise and they are making a lot of mistakes. Its

fine to make mistakes as you learn, but its better to

make them on small things than big things.

Some companies spend billions of dollars building

plants and then recognize that theyve made

mistakes. The biggest mistake that they often

make is to duplicate a plant that they have either

in Europe or in the U.S. And because in low-cost

countries the value is in the low wages, you dont

necessarily want to put in a lot of automation. If

youve put in a lot of automation, of course, you

havent taken advantage of the fact that the wages

are lower.

Knowledge@Wharton: Can you think of any specific

examples of things companies should be doing

differently, if they havent quite yet done everything

perfectly, so to speak?



But weve also seen companies make some very

smart decisions. Im thinking about a French

company that makes a tri-metal alloy for which the

end part of the production process is the important

part of the intellectual property. They made a

decision not to bring that technology to a low-cost

country, but to keep it in France even though it costs

them more. They put all of the complex assembly in

China, but ship the tri-metal from France to protect

their intellectual property.

Knowledge@Wharton: Can you take a minute or

two to talk about your forthcoming book called

Globality?What does it entail?

Sirkin:Globalityis a book that we believe takes

a very different perspective on how all of the

competition between companies will go forward

in the future. Its subtitle says a lot about what

it is, which is Competing with Everyone from

Everywhere for Everything. And by that we mean

that your competition will change and you will be

competing with everyone not just your traditional

competitors [including] new companies from

countries like China, India, Brazil, Russia, Eastern

Europe, Southeast Asia and just about everywhere.

The second point is that competition will come

from everywhere. Your competitors will no longer

look a lot like you. It may be a small company in

Indonesia. It may be a large company in China.

It may be a big-sized company in India. But,

competition will be coming from everywhere and

competing for everything. By everything, we mean

for resources, for people, for customers, for distri-bution systems and for supply chains.

Were expecting a wealth of competition to spring

up because companies from low-cost countries are

moving from being outsourcing vehicles for the

traditional Western multi-nationals, to becoming

companies in their own right that are growing and

growing rapidly. So you see companies like Tata

Steel and Mahindra that are starting to take roles

on the global stage, with their own brands and their

own products. They should not be ignored.

Globalitylooks at not just the Western companies,

the traditional multi-nationals, but the new emerging

companies that are starting to become large and that

are challenging those multi-nationals, and what the

lessons are both for emerging companies and, more

importantly, for the multi-nationals.

Knowledge@Wharton:The book has been written by

folks at BCG?

Sirkin: Yes, myself, a colleague from China, and a

colleague from India.

Knowledge@Wharton:Before we wrap up theinterview today, is there anything that you would

like to add that we have not talked about, any

important points that you think our listeners should

take away from our conversation, and that we

havent gotten to yet?

Sirkin: Yes, the most important point is to seriously

consider your procurement on a global basis. Some

companies have jumped in too quickly and too fast

and havent thought it through, whereas others are

sitting back and saying, This is a lot of work, and

I dont really want to do it. For that last group, I

would caution them and say, If you can get a 20%

cost savings in a business that might have a 10%

or 15% margin, that creates a massive competitive

advantage.

You can forego that competitive advantage, but

if you do, one of your competitors will eventually

figure it out, and youll be at a competitive disad-

vantage. Theres a value to going early, and theres

a value to making sure that you go slowly enough

that you get it right, but quickly enough that your

competitors dont get ahead. v



Challenges Facing Procurement Organizations

Procurement has become an integralpart of corporate performance and is drawing

increased attention from senior management.

In this interview, Andreas Gocke, a BCG partner

and managing director, spoke with Knowledge@

Wharton about the most critical challenges facing

procurement organizations over the next five to 10

years, including training and employee development,

managing global sourcing offices and ensuring col-

laboration across corporate departments.

Knowledge@Wharton:Can you talk a little bit aboutthe biggest challenges that procurement organiza-

tions face today?

Gocke:BCG did a procurement roundtable withabout 30 European CPOs. We did a quick survey

about the most challenging topics for the next five

to 10 years. Surprisingly enough, people training

and development was the number-one topic as

the key challenge for procurement organizations.

That includes: skill development; the right recruiting

and retention practices; and career paths in other

functions outside of procurement.

Number two was also related to organizational

aspects. It was the organization of global sourcing.

That is, how to set up and how to manage globalsourcing offices. That is also more in terms of

processes, a linkage between the global sourcing

offices and the headquarters. Its also how the

global sourcing offices do work with other non-pro-

curement functions.

And number three is cross-function and collabora-

tion. That is, how does procurement work with not

only engineering and quality management which

has been the nature of the procurement departmen

for a long time already but also with other

functions like sales and marketing when it comes to

requirements management? Thats also with finance

and controlling, and thats also with logistics and

supply chain management.

These are the top three: people training and

development, global sourcing organization, and

cross-function and collaboration.

Knowledge@Wharton: Are those three much

different from the challenges that faced

procurement people 10, 15 or 20 years ago?

Gocke:I would say that 10 or 15 years ago,procurement was still fighting for, lets say, orga-nizational significance. Have they listened and do

they have the right organizational position? In most

organizations we see right now, this point has been

reached already.

Theres not so much a challenge anymore for

procurement to be accepted as a strategic business

partner inside the organization or to be accepted

as the adding-value partner in the organization.

We did a quick survey about themost challenging topics for the next

five to 10 yearspeople training

and development was the number-

one topic as the key challenge for

procurement organizations.Andreas Gocke, partner and managing director,

BCG

4



So now its more how to move forward in this

significant strategic position inside an organization.

The war for talent [is seen] in all three regions, by

the way. Its not only a European or an American

issue. People, people, people will also face the

procurement department, for sure.

Knowledge@Wharton:You mentioned a moment

ago that procurement has become more accepted

as an integral part of organizations. Therefore, it

seems like its more strategic than ever. Can you talk

a little bit about the reasons why thats the case?

Gocke:If you look into major global corpora-tions profit and loss accounts you see the answer

already. The share of material costs and the share

of purchased services are growing continuously.

We have some comparisons. What kind of external

delivery for automotive OEMs, for instance, is like

that the pacesetter of these developments [over]

the next couple of years? The ratio is between 5%

and 10% in absolute terms per annum over thenext couple of years. Thats a very quantitative

aspect. But if you see the qualitative aspect as well,

sourcing now also becomes the gatekeeper for

supplier innovation.

The technology competence with suppliers is

growing more and more. You can easily measure it

by the number of patents which are applied for in

many industries. And even in the customer organi-

zations, the supplier will influence our technological

development more and more. Therefore, sourcing

will be the organizational unit which will managethese aspects.

Knowledge@Wharton: If procurement is becoming

increasingly important and strategic, getting back to

something that you mentioned, which was retention

and development of key people in this area, where

are organizations finding the best people? How do

they go about doing that and is it a difficult task?

Gocke:This is one of the key questions where weneed to confess to not having the right answer

yet. CPOs dont have the answer either. Unlike

most other functions, there is not the academicpurchasing manager education. You dont find, or

very seldom find, a master education in purchasing.

Very few universities around the world really focus

and specialize on purchasing as an education path

by itself.

So, we are working with our clients to develop

those career paths by themselves. They cannot

wait for the outside world. They need to develop it

internally by setting up career paths across different

functions, by setting up education programs for

hard skills language, engineering, etc. and

also soft skills, which are becoming more and more

important, like project management, working in

different cultures, and working in different business

contexts. These skills need to be developed by your

own organization. Dont wait for the outside world

to support you on this.

Knowledge@Wharton: And because global sourcingis the second of those three important topics that

were discussed at the summit that you talked about

a little while ago, it would seem that the type of

people that would be best suited for global sourcing

would be people with the kind of skills that you just

mentioned also a moment ago.

Gocke:Yes, and I would even stress that they haveadditional skills. If you need to set up a global

sourcing office somewhere in China or in India, its

more entrepreneurial groundwork, so to speak. And

the people there need to be much more like entre-

preneurs. They need to improvise.

They need to bridge their home organizations

their headquarters with their local supplier

markets. So the intercultural management skills

are regarded as even more important than that of a

domestic purchasing manager.

Knowledge@Wharton:Is being a purchasingmanager or a chief procurement officer, or

whatever the organizational title happens to be a

good career path for those people? If procurement

is increasingly important, is it a good idea forpeople to seek those jobs out, if they think that they

can do well at them?

Gocke:In terms of status quo, I would be honestand rather critical. In terms of potential, I would be

very positive. Let me just talk about the status quo

and those managers who traditionally are in sales

and marketing. Those who contribute to the top

line are still regarded as contributing the most to

corporate success.

Those who improve the bottom line [with things

like] cost improvements [and] volume reduction still have less of a reputation [for] contributing to

corporate success. This is changing. As I mentioned

in my answer five minutes ago, as purchasing

becomes more and more the gatekeeper for

innovation of suppliers, for instance, this innovation

some time later will result in additional sales.

Suddenly, you have a bridge from supplier his

innovation power bringing this innovation power



6

into the customer organization, thereby developing

more and more to customers innovation and

thereby contributing to our own corporate success

on the top line. So, suddenly purchasing not only

becomes a bottom line impact, but also a top line

impact, and at this moment the sales purchasing

manager has a huge potential.

We see that also reflected in the corporate orga-

nizations. More and more organizations in theautomotive industry, which is like the front runner

in this dimension, have a CPO function on the board

level. That had not been the case some 10 or 15 years

ago. In most organizations, the CPOs reported either

to the chief technical officer, the chief engineering

officer, the COO, or the CFO. Now we see that the

CPO has his own position in the organization.

Knowledge@Wharton:Lets address the issue, if wecan, about the importance for procurement to work

in tandem with other functions in the company.

Could you say that at one time procurement was

more of a standalone kind of operation, off to the

side, and that its more integrated today? Would that

be accurate?

Gocke:It depends. If we see the history ofpurchasing then that would give you a kind of

maturity progress. And when we see different

organizations across history, we see six different

steps. The first step was [something] like Serve

the Factory, if you call that the theme. Purchasing

was more in clerical and logistics activities, so these

skills were requested.

The next step was more like reaching the lowest

unit cost. Call this theme, Lowest Unit Cost. Here

the purchasing organization was [focused on]

pushing and pressing the supplier, and negotiating

tasks, and that was sufficient enough. Suddenly,

[we had] the third step we will call this theme,

Coordinated Purchasing. Sourcing needed to have

the input of other functions to make the supplier-

customer relationship better.

In the fourth step, we had the theme Cross-

Functional Purchasing, which is what you asked

about. Suddenly, the purchasing department was

an equal part across different functions, in which all

contributed to the corporate success. Each function

was dependent on the other, especially technical

improvement leaders like make or buy; like standard-

ization; like design to cost and process improvement

leaders; [and] like demand bundling. So, to enable

those leaders, you need to have cross-functional

work, where purchasing is across engineering,

quality management, and sales/marketing.

The fifth step is World-Class Supplier

Management, and here you have even more of

an intercultural aspect. And, the sixth step, which

we regard as the highest aspirational level, is

Entrepreneurial Purchasing. And with entrepre-

neurial purchasing, purchasing behaves like a cost

and profit center as well.

And so, they are building up supplier networks by

themselves. They are offering supplier networks

to the rest of the organization. They bring in ideas.

They are the gatekeepers of suppliers ideas into th

organization. So, purchasing is not reacting to the

organization demand, but it is vice versa. Sourcing

brings in its own initiatives and thereby triggers the

rest of the organization.

Knowledge@Wharton:Thats a very important

point. A few minutes ago, you mentioned again

as one of those important themes that emergedfrom your meeting on global sourcing: Does global

procurement, in your view, demand any special

skills or organizational needs?

Gocke:Yes, and I think thats the reason why manyorganizations are not where they want to be with

regard to global sourcing. Global sourcing is not

just identifying the Chinese supplier in mainland

China, signing the contract, and thats it. Its the

need to change the entire sourcing process.

What do I mean by that? If you are really taking

global sourcing seriously, you need to sometimes

extend your development process to allow a longer

screening phase from your suppliers, to allow

longer trial periods with new suppliers, etc. If you

dont reflect that in your incumbent processes, you

will not have success with global sourcing.

And this also then comes into play for the need in

the organization to reflect those requirements in

terms of processes. So you need people and also

departments who know how to deal with those

challenges. For a global sourcing organization you

need to ensure that the global sourcing officesaround the world have equal power with their, lets

say, competitors inside the headquarters organiza-

tion which do domestic or just regional sourcing.

You sometimes need to have more resources

because you need to write specifications sometime

in the language of the global sourcing country, like

Chinese. In India it is mostly English, but in China,



its a huge challenge. Eastern Europe is also a huge

challenge. You need maybe more resources in terms

of supplier qualification management. So in terms

of skills, resources, and new processes, organiza-

tions need to learn more.

Knowledge@Wharton:Youre based in Munich,

Germany. Do you see any significant differences

between the way companies in Europe and

companies, say, in North America approach thewhole topic of purchasing?

Gocke:Yes, in maybe two dimensions, I wouldsay. For the first dimension, Im rather sure. The

second one is still at the hypothesis level. The first

one is the openness toward global sourcing, since

Europe has its global sourcing market directly

next door, which is Eastern Europe. And lets say

Western Europe [has become] used to working with

Polish, with Czech, and also with Turkish suppliers

[over] the last 30 and even 50 years. Its still a huge

challenge to expand this global sourcing level

toward Asia.

And thats the big difference with U.S. purchasing

organizations. They might have a link toward Mexico

in the NAFTA region. But this is not comparable

to dealing with 10 to 12 different Eastern

European countries including Turkey and

then [expanding to] 13 or 14 countries. This is the

difference.

Number two is that there might be a slightly

different understanding in terms of supplier-custom-

er relationship management in Europe comparedto the U.S., especially with the automotive industry.

The openness for more trustful supplier-customer

relationships is slightly higher and more developed

in Europe.

But we see that the Big Three in Detroit are also

opening up more and are seeing some successful

models in Europe. They have learned that they

cannot rely on those supplier-customer relationships

which are doomed to fail because they are just built

on market power.

That will not be successful and the result, unfortu-nately, is that many tier one suppliers are close to

bankruptcy and are not managed well. There needs

to be, I would even say, a turnaround management

for most of the relationships.

Knowledge@Wharton:Well, from everything that

you have discussed today, it certainly sounds as if

purchasing will only become more important in the

years ahead, for organizations of all kinds.

Gocke:Yes,Im pretty sure of this. The technologyindustry and the automotive industry I think

they have already put sufficient emphasis on the

procurement organization, and their reputation is

higher. As I mentioned, we have a CPO on the board

level. We have cross-functional teamwork. We have

more and more sophisticated supplier-relationship

management tools and also processes.

And now [its spreading] to other industries as well,like the machinery industry and also the utilities-

supplier industry. So, I definitely agree with your

observation that purchasing will become more and

more relevant in strategic function. v



Marshal l L. Fisher, director of WhartonsFishman-Davidson Center for Service and Operations

Management, has been researching issues related

to retail supply chain strategy for many years. In this

interview, Fisher highlights some of the challenges

facing global procurement, and he discusses

the example of Luen Thai, a Chinese company

that built a giant supply-chain city, becoming a

one-stop shop for clothing manufacturers looking to

outsource to low-cost producers.

Knowledge@Wharton: Before we began recording

our conversation, you were talking about some of

the interesting and far-reaching changes that have

occurred in the area of procurement in the last 10 or

20 years. Can you tell our listeners a little about that?

Fisher: Id be happy to. My knowledge on this isbased on working with a number of U.S.-based

product companies on supply-chain strategy and

Ive been struck by two phenomenons: outsourcing

and offshoring of their manufacturing operations.

In the 1980s, thinking back a couple of decades,

there was a pretty vigorous debate within the U.S.

about the need to strengthen and preserve U.S.

manufacturing. This is a time when the Japanese

economy was in its ascendancy, and it was believed

that was due to their prowess in manufacturing. The

belief was that you couldnt have a viable economy,

particularly the U.S. economy, without strong manu-

facturing. So the message was: Keep manufacturing

in the U.S. and make it stronger.

Boy, things have changed a lot in the last two

decades. Most companies now are outsourcing

and offshoring manufacturing vigorously, almost to

the point where you will find companies that dont

make anything themselves or in the United States.

Its going to low-labor-cost regions, predominantly

Global Supply Chain Strategy

Asia, Eastern Europe and Latin America, and, within

Asia, predominantly China.

I wrote a case on a very interesting Chinese

company called Luen Thai, based in southern China

Theyre the largest private-label apparel manufac-turer, so they make for large retailers [like] Gap,

Limited, Dillards, or branded apparel companies

like Liz Claiborne in the United States and some

European companies.

And theyve done a phenomenal thing. Theyve set

up this supply-chain city, which is a massive facility

probably the largest apparel production facility in

the world, intending to leverage a change in trade

regulations that happened Jan. 1, 2005.

Prior to that, apparel production was heavily

regulated. There were quotas as to how much anycountry could export to the United States by variou

categories of apparel, which caused apparel to be

spread all over the world. But basically, [it was] a

fragmented supply chain with production in lots

of different countries because no one country had

enough quotas to supply the industry needs.

That quota system was ostensibly eliminated Jan.

1, 2005. And if you look at other categories, say

toys [or] consumer electronics, where there is no

quota, youll see something like 80% to 90% of

the production coming out of China. So Luen Thai

believes thats going to happen in apparel and they

set up this giant supply-chain city to leverage that.

Knowledge@Wharton: Now this giant city that

youve mentioned, thats very interesting because

that was a step that Luen Thai took after looking

at the landscape for world manufacturing and

coming to a certain set of decisions as to how

it was going to respond to these changes. What

sorts of challenges has Luen Thai faced and what

8



have they done, in addition to building this large

city for its workers and its production? What sorts

of things has Luen Thai done and what kind of

takeaways might there be for our listeners who

want to learn more about the way a giant Chinese

company goes about doing its business in this kind

of environment?

Fisher: Well, some of their challenges are perhaps

unique to apparel. So in that category theres alot of political pressure to continue some form of

restriction on apparel imports. Theres a provision

called safeguards that limit [and] that kind of put

back quotas to some extent.

That lesson is less transferable to other cross

segments where you dont have those same restric-

tions, such as toys and consumer electronics. The

other thing they have been struggling with, which

might translate to other industries, is essentially,

whats the best place to locate various functions? So

you think about all the steps involved in sizing up

a market, designing a product, and then producing

that product. What gets located where?

So Luen Thais original vision is: Well do it all in

China. Well do design in China. Itll be one-stop

shopping for apparel buyers. So theyll fly over,

well give them really nice offices just like their

offices back at home, and we can quickly design a

garment, make a prototype, get that critiqued by the

buyers, and redesign it within a few hours. This is a

process that used to take a few weeks to go around

that iteration loop.

What they found out is that total outsourcing from

original conception of the design of a product

through production and delivery to the store

they call it design-to-store doesnt work. Why?

Number one, designers dont want to live in

southern China. They want to live in the fashion

capitals [like] Manhattan.

Knowledge@Wharton: Sure.

Fisher: So its hard to get creative people to go

there. The Chinese are turning out their own

designers, but they dont have the reputation andprobably not the skill of U.S. designers. And then

secondly, it helps a lot to be close to the market. So

theyve been evolving close to the market youre

designing for, to understand the end-consumer. So

theyve been refining that concept and their thought

is that theres a customer-facing aspect of design.

In apparel, whats the artistic look of the garment

that would appeal to a particular customers look

and feel?

And then theres a production-facing design. For

example, a garment is a three-dimensional object

made from two-dimensional pieces of cloth. So

theres an engineering function called pattern-mak-

ing that translates that three-dimensional object into

a series of two-dimensional shapes cut out of cloth.

That engineering-production-type step could be

done in China with an interface between them.

So as supply chains become global, companiesneed to think about what they put where and how

they coordinate across those various functions.

Knowledge@Wharton: And in the case of Luen Thai

Holdings, that was a major decision, was it not?

Fisher: It was absolutely a big bet. Theyre a fairlyold company, and they had thrived under the old

quota system. One of their people joked that if you

had a sewing factory and owned quota, which is the

right to export to the United States or Europe, it was

like a license to print money. And we printed a lot of

money. But [after] Jan. 1, 2005, that quota system

was going to go away, so their license was about to

be revoked.

And several years prior to that, they started

thinking, Life is good, but we cant continue in that

old way because this elimination of quota is goingto change things, so we need to have a plan. And

this was their answer.

Knowledge@Wharton: Now, did Luen Thai have any

difficulty convincing its customers in North America

and Europe and elsewhere that this design to

store concept would work for them?

Fisher: Absolutely, because apparel buying is

highly cost-driven. Why? Cost is very visible, so

design-to-store [outsourcing]

doesnt work. Why? Number one,

designers dont want to live in

southern China. They want to

live in the fashion capitals [like]

Manhattan.Marshall L. Fisher, professor of operations

and information management, Wharton



10

a buyer knows whether or not theyre getting the

lowest cost. If they pay a higher cost, but they get

additional service, well, its hard to evaluate what

those services are worth. Its a qualitative judgment,

which is harder to size up.

So theres a bias toward basing decision-making

on the tangible, highly knowable cost. And buyers

will move production for a few pennies a garment

because its a highly competitive, cost-driven industry.Its sometimes called chasing the cheapest needle.

And youll see apparel is a great way for a country

to move up the economic ladder because you can

start out making easy-to-produce stuff like T-shirts.

Its very easy to find used sewing equipment [and]

low-skill labor, so any underdeveloped country can

get started that way.

But then they move up the ladder.... China was

there maybe 20 or 30 years ago, but gradually

over time, theyve moved way up in their skills and

sophistication. And with it, wages have movedup, so Chinas no longer the dirt cheap, lowest

cost production site. So what you see happen is

companies will move to a much less developed

country, maybe Bangladesh ... because wage rates

are lower [and] you get lower production costs

chasing the cheapest needle. So its hard to

compete on service in a cost-driven industry. Thats

one of the challenges that Luen Thai has faced.

Knowledge@Wharton: Thats why the company had

a bit of a challenge in store for it when it tried to

convince its customers that their model ...

Fisher: Yes, they did. They absolutely did. Their

concept, I think, makes sense. You look at the costs

to design, produce and deliver a garment to the

store. Only about a third of that cost is manufac-

turing cost, and thats the cost that all the buyers

gravitate to. The other two-thirds are soft costs:

design, logistics, handling, [and] transportation. So

Luen Thai wants to attack that other two-thirds and

try to improve on that.

Knowledge@Wharton: Is the model that it has

devised being copied by other manufacturers inlow-cost countries?

Fisher: I think its almost the other way around. In

industries like consumer electronics, which have not

had the same degree of trade restrictions as apparel

has had, theyre much further along in the supply-

chain-city concept.

Id visited Luen Thai in the summer of 2006 and [on]

that same visit I spent a day at a Chinese company,

Taiwan-based, in the U.S. called Foxconn. In China,

theyd be called Hon Hai. And Id not heard of

them previously. I was surprised to find out theyre

about $32 billion in revenue. Theyd be a Fortune 50

company if they were based in the U.S.

They produce all of the branded consumer products

So they produce for Dell, Motorola, and Apple you name it all the well-known companies. This

is one of 12 facilities, and I was struck by the size

of it. And I asked somebody how big it was, and

they said, Well, let me put it this way. You came in

the front gate, and if youd started walking from the

front gate toward the back gate, it would take you 4

minutes to get there. So [with] 245,000 employees

[its] literally a city [with] their own police force,

hospital, [and] school.

Knowledge@Wharton: Thats remarkable.

Fisher: Its remarkable whats happened. I was trulyshocked at the scale of outsourcing, offshoring, the

degree to which China has become a juggernaut,

almost resembling Japan in its ascendancy in the

1980s.

Knowledge@Wharton: Thats an interesting point.

And of course, Japan, which began post-World War

II as a low-cost manufacturer, grew its economy

tremendously ...

Fisher: Yes.

Knowledge@Wharton: And moved out of thatbracket to become the worlds second-largest

economy. Do you see the same thing happening

for China? Are there any differences with the Japan

experience? Or is China mostly similar to Japan in

the way its growing its economy now?

Fisher: Thats a very interesting suggestion. Im sure

there are differences, but Im struck more by the

similarities. It looks very, very similar. Post-World

War II Japan was very, very low-cost labor. Made

in Japan was, at the time, synonymous with low

quality. China, in the 1980s, looked the same way.

Now, 20 years later, Chinas synonymous with

high quality, just as Japan became synonymous

with high quality. It looks very similar. Its almost

following Japan, 30 years lagged.

And theyre starting to have some of the problems

that Japan had as they became more prosperous

and it was harder for them to compete at low

wages. Chinas running into rising cost pressures.



There was a student of mine. His name is Gang Yu

[and he] grew up in Wuhan, China, got his Ph.D.

at Wharton, taught at the University of Texas for a

while, and then left [as] the VP of supply chain at

Amazon, and now he runs Asian sourcing for Dell.

So I stay in touch with him.

And when I got back [from] this visit to Foxconn, I

was truly blown away by what a powerhouse China

had become. And he said, Well, dont worry toomuch. Weve got our problems in China. And he

talked about rising costs [and] lack of labor avail-

ability so it was labor scarcity pushing up costs

[which were] some of the same things that began to

afflict the Japanese economy in the early 1990s.

So it will be interesting to see. Maybe interesting

is too weak a word. It will be highly important to see

what is going to happen in China.

Knowledge@Wharton: Well, China of course as you

well know has faced a lot of bad publicity here in

the U.S. and elsewhere for shoddy products beingshipped to the United States, is that a reason for

Fisher: They are second only to Wal-Mart in the bad

press they are getting.

Knowledge@Wharton: Is that a reason for concern

on the part of their customers here and elsewhere

who might have turned to China in the explosion

of outsourcing abroad only to find that there

have been some serious drawbacks. I mean how

should customers here in the U.S. and Europe and

elsewhere think about these problems that China

has had with quality?

Fisher: I am not sure whether their quality problems

are any more frequent or greater than if those same

products, say 40 years ago, were being produced

in the United States because there would be quality

problems then, too. You may recall there was a big

tire recall in the U.S. 10, 20 years ago. So that is

kind of point one. I dont really know the objective

facts on whether this speaks to substandard quality

coming out of China. It is a different government

regulating quality than when you are producing

in the U.S. and it was your government, the U.S.government, regulating it. So I guess the phrase,

Trust but verify, would come to mind.

Knowledge@Wharton: Before we end our con-

versation, I did want to loop back to something

you began discussing in the beginning of our talk

which was the tremendous change in outsourcing

in the last couple of decades. Do you think that

companies in North America and Europe and other

developed countries have responded well in seeking

out countries like China and India, etc? Have they

mostly done the right thing in finding the right

partners to do business with and in approaching

that issue in the right way? Are they getting the

most benefit from it or are there still areas where

there could be some improvement on the way firms

in developed countries go about their purchasing

and procurement activities abroad?

Fisher: Well obviously, the answer to your question

is yes and yes. It is a complex subject, but on

balance I think that they are doing more things right

than wrong, but of course there is always room for

improvement. Having looked through the 1980s and

teaching operations management at Wharton, it was

almost like a religion that real men did manufac-

turing and real economies did manufacturing. And

so it was troubling to me the idea of hollowing out

the U.S. economy.

But if you think it through, all work this is a slight

oversimplification, but not much can be divided

into muscle work and brain work. And so what we

are doing right now talking to each other is mostly

brain work. A lot of manufacturing is a blend of the

two, but many types of manufacturing are more

muscle work than brain work.

So brain work tends to pay better than muscle work.

So if an economy wants to ascend, it has to be

carefully managed, but it makes sense to offshore

and outsource the muscle work to low-wage-rate

countries and retain the higher-margin brain work.So in manufacturing product companies, that would

include things like market research and product

design.

Now that certainly makes sense, but you better

be very sure that you are excellent at the brain

work. It is not enough to say, We are going to

do the product design and marketing and then

produce me-too products or ho-hum, uninteresting

products. Youve got to really be world-class at that.

Because these low-cost-labor countries that we are

outsourcing to, they want to get into the brain-work

game, too. So you see Chinese companies, for

example Foxconn on their corporate video. They

started out in 1970 making TV knobs, if you could

believe that, the most pedestrian product you could

think of. Now they have gone to making really

high-tech stuff, but it is largely based on low-cost

labor. They want to get into innovation.



12

So, it is a little bit like riding a tiger, I think, that in

outsourcing to low-labor-cost countries you get a

short-term benefit, but there is the risk you may be

spawning a competitor.

Knowledge@Wharton: That is an excellent point,

and is it one that firms in the U.S. and Europe are

going to have to worry about in the next five to 10

years? As you well know there has been a lot of

political consternation over the quote-unquote lossof jobs in America to low-cost countries if indeed

the brain work, so to speak, is going to be the next

challenge to be faced by, say, U.S. firms. Is it a real

reason for concern? Could the Chinese and India be

critical competitors to U.S. companies in that area?

Fisher: Absolutely they could be. I think the key to a

prosperous economy is to compete on things that pay

well. Brain work, I think, pays well. I think implicitly

or explicitly by outsourcing labor-intensive activities,

anything from manufacturing to call centers, to low-

labor-cost countries, the U.S. is moving down a path

of competing on brain work. But that implies a whole

bunch of things. Like you better have a very good

education system or else segments of society get left

behind in the U.S. So there are a lot of challenges I

think our economy is facing.

The education systems in foreign countries are quite

good. Right now, labor rates are low there. Theyre

also low for professional services, so you are seeing

brain-work-type activities getting outsourced to

low-labor-cost countries, not to laborers but to

engineers. So software going to India would be an

example.

Knowledge@Wharton: Is there anything in terms

of research that youre working on now that might

be pertinent to what we have been talking about?

You wrote the case study on Luen Thai, which you

shared with us today. Is there anything else that you

are working on right now that might be of interest

to readers and to follow up on when that project is

completed?

Fisher: Right now, and really for the last decade, my

research has been focused on retail supply chain

management and Ive been led to be intrigued with

and aware of these global issues because retail

supply chain management has come to mean global

supply chain management. So I havent focused

explicitly on that in my research, but I was so

intrigued with this, I am planning to introduce an

MBA minicourse next year on global supply chain

management, almost as a way to launch a next

wave of my research on that topic.

There is a joke that the first time a course is taught,

the instructor learns. The second time, the students

learn. And this is probably overly harsh, but then

the third time, nobody learns.

Knowledge@Wharton: Well, they move on to

something else. v



In the never-ending quest for costsavings, many companies have reduced the number

of suppliers they use, consolidated their purchases,

and negotiated better prices. So, where can chief

procurement officers and other managers now turn

for savings? In this interview, Bob Tevelson, a BCG

partner and managing director, says firms must

segment suppliers to identify those that can deliver

what he calls partnership value by establishing rela-

tionships that move beyond the transactional level.

Knowledge@Wharton:Many companies havealready reduced the number of suppliers that they

use and consolidated their purchases and negotiated

better prices. Where do you think the next level of

cost savings will come from in procurement?

Tevelson: I think many companies have, in fact,reduced the number of suppliers they work with sig-

nificantly, but I still think there is an opportunity to

do more. I think what the next level of benefits will

accrue from is looking at the suppliers that are used,

the smaller subset, and really segmenting those.

What I mean by that is breaking them into different

groups in terms of what were looking for from

the suppliers and taking the supplier-relationship

management to the next level, which is to segment

based on what the suppliers can do versus our

objectives, and then being willing to invest in those

suppliers to be able to drive value.

Knowledge@Wharton: What are the biggest

challenges that companies face today with regard to

suppliers?

Tevelson: I think the biggest challenge is to be able

to segment the suppliers into those that are really

meaningful and can deliver partnership value. What

I mean by that is moving beyond the transactional,

Building Customer-supplier Relationships

moving beyond getting a better price, [and] moving

to some of the more interesting areas around real

collaboration [and] trust-based relationships.

Also, taking the focus beyond the transactional

[and] beyond the day-to-day, looking at what thesupplier can do from an innovation perspective

to drive where the company is focused from a

strategic perspective, and also focus on driving

performance to the next level.

Knowledge@Wharton: Youve raised some

interesting issues, so lets pause for a second and

talk about how supplier relationships have changed

over time and some of the changes youve seen

happening. What has been the genesis for that?

Why have companies changed their relationships in

recent years?

Tevelson: I think theyve been forced to change.

If you take the automotive industry, for example,

and the economics they face a couple of years

ago, when profits were up, the focus was all about

partnering, tight relationships, and sharing benefits

and innovation. Then, when the chips are down, the

focus is more on the dollars and more on price.

The next level of benefits will

accrue from looking at the suppliers

that are used, the smaller subset, and

really segmenting those.Bob Tevelson, partner and managing director

BCG



14

And so, theres a natural ebb and flow cycle to

relationships. I think what companies are finding

now is that margins are pushed down to where

suppliers are making a reasonable profit and getting

a reasonable return, [and] that they need to find

other ways to get more value from the suppliers,

and it goes back to segmentation. Who are the core

suppliers you want to work with? Why do we want

to work with them? What can they do?

What they can do is beyond price. Its innovation,

its helping us go to market, and its working with us

to understand our business better and identifying

best practices.

Knowledge@Wharton:Are there differences amongindustries? Youve mentioned, for instance, the auto

business, which is certainly one that we read about

all the time in the press, trying to control costs

through their relationships with suppliers. But are

there differences, say, between the auto industry

and other industries?

Tevelson: I think theres a significant difference, and

youll find relationships varying by industry. If you

take the automotive industry, its more arms length.

High-tech is more integrated. Its more integrated

because obsolescence happens so fast that we

have to have tighter relationships. We also have to

leverage the capability of suppliers to be able to

drive product development, innovation and the fast

cycle times in the supply chain.

Knowledge@Wharton:Does that mean that,necessarily, things are more difficult, say, forhigh-tech firms as opposed to autos, or is it just a

matter of difference and not really levels of difficulty

in managing these relationships?

Tevelson: I think the value is different and what

the suppliers can do is different. But also, history

is different. So, the automotive industry is starting

from a base where theres less trust because

theres been this great focus on price and making

agreements and then pushing suppliers further.

With the high-tech industries, for example, theres

more collaboration.

Another example would be the pharmaceutical

industry, where some partnerships are emerging

even in mundane categories like packaging.

Companies are working with their packaging

suppliers to differentiate not only based on

marketing opportunities, but [also] based on the

customer experience with the package from a safety

perspective [and] from an information perspective.

And ultimately, what the pharmaceutical companies

are interested in is the patient using the prescrip-

tion, persistence and compliance.

Knowledge@Wharton:You mentioned trust, whichis something we want to talk about in a moment,

but how can companies prepare for the changes

youve described, and what will these supply rela-

tionships look like in the future?

Tevelson: I think companies can prepare by

undertaking some basics of understanding their

supply market and then understanding from that

where they need to go with the business. So, how

can procurement contribute to the company goals?

And therefore, what do our suppliers need to do?

Then, setting kind of a baseline as to where we are

from the starting perspective, what are we securing

from a value perspective, and what do we really

need to get from our suppliers going forward?

Knowledge@Wharton:What will those relationshiplook like, do you think?

Tevelson: I think the word partnership is always

thrown out, so lawyers jump in and they get all

upset about the implications of that. But I think wha

youll find are tighter, longer-lasting, integrated

relationships that are based on trust [and]

information sharing, while the contract will sit

behind and ensure the right incentives are in place

on both the upside and the downside. I think youll

see more integrated relationships [and] deeper

investments by both parties with fewer suppliers.

Knowledge@Wharton:Can you talk about theimportance of trust in relationships and maybe eve

discuss the possible consequences that can arise

when trust is lacking or is weak?

Tevelson: Thats very interesting because I dont

believe personally that a good, deep, collabora-

tive relationship can exist without trust. I think its

a table stake that one has to have going in. If you

dont, one is always holding back either information

or opportunities. If you dont have good collabora-

tion, too much energy and focus is concerned with

whether the agreement and the situation is fair.I think that undermines the ability to really drive

forward and get after the most value.

So again, I think its a starting point that has to exist

You segment your suppliers. Are they important

from a strategic perspective to the business, and

where are they along the continuum on the trust

matrix? What do we need to do [to] move it to the

right place?



Knowledge@Wharton:Do you think, in general,that trust has eroded between suppliers and their

customers in recent years, and if so, why do you

think thats happened?

Tevelson: I think it varies by industry, and in the

automotive industry there has been clear erosion. In

some of the high-tech industries there has been less.

You also need to think about the whole movement

of supply chains and supply sources overseas wherethese long-term relationships may exist.

Lower-priced suppliers, perhaps without the same

sophistication, are brought to the fold. Then you get

a conflict between the value a domestic supplier

can provide around innovation, around speed,

and around helping their customers operate more

efficiently and effectively versus the offshore supply

base, which has a great advantage around price but

not necessarily leading-edge innovation or speed in

the cycle chain, the supply cycle.

Knowledge@Wharton:What types of valuea wordagain that you mentioned a little while agocan

advanced supplier relationships offer?

Tevelson: I think value is really changing the rules of

the game. If youre effective at procurement, youve

already pushed down pricing with your supplier to

the point where theyre making a reasonable return.

[If you] push it too far, theyre not going to be happy

or a long-term supplier. Its really around driving

changes in supply chains opening up the infor-

mation-sharing and looking at how we can change

the interface, how we can change processes to takeout time [and] take out inefficiency and cost.

Also, how can we change what we buy so that we

may be able to take advantage of specifying to

needs versus wants and coming closer to what the

customer needs versus overdelivering? Suppliers

have a lot to offer when asked the question, and I

think its critical that you have these types of rela-

tionships so that you leverage that insight. They

have a good perspective, and its only a value if it

can be leveraged.

Knowledge@Wharton:If we can try to pull all thistogether, what do you think the common themes are

for success in these very important relationships?

Tevelson: I think there are a couple of things and

Id start with clear segmentation of suppliers. You

cant have deep, collaborative relationships with all

your suppliers, and you need to really identify which

ones are the players. The second issue is senior

management buy-in. And while it seems obvious

that in many corporate initiatives you need to have

that, Im talking about buy-in to the point of differen-

tiated investment and investment in terms of dollars,

investment in terms of senior management time,

participating in conferences, [and] participating in

discussions with suppliers directly and indirectly.

I think the other issue is developing a track record

of success, being able to identify prior successes,perhaps pilots or case studies that can be com-

municated and provide justification to extend the

program. Another key is treating the suppliers well.

They have to have some vested interest in partici-

pating, so the benefits, the savings, the improved

cycle times, [and] the opportunities need to be

jointly shared.

Im not sure if its a 25, 50, 75 sharing, but at some

point the suppliers need to have an incentive to

participate, which is my last point. [You need]

common objectives common objectives

internally, common objectives with the suppliers,

and [you need to] make sure theyre aligned

incentives. We all know what were going after and

we know why were going after it, and then there

are incentives to support that.

Knowledge@Wharton:Are there any issues that wehave not discussed that youd like to bring up? For

instance, I dont know if weve really talked about

price volatility and how that can affect supplier rela-

tionships. Maybe theres something else youd also

like to bring up?

Tevelson: I can talk about the price volatility and

also supply-chain risk, which is somewhat related. In

terms of supply-chain risk, these tighter supply rela-

tionships enable companies to share and develop

contingency plans. So, you may choose to go with

one supplier, but work with that supplier to develop

a contingency plan around what will happen if

theres a natural disaster. Then, from a price-volatil-

ity perspective, its really hard to have a collabora-

tive type of relationship if the risk is disproportion-

ately burdened or borne by one of the two parties.

So often, when theres a lot of volatility in the

pricing or economics of the relationship, you can

establish some type of risk-sharing and the right

level of divisibility so that no one is taking on an

undue burden of that risk.

Knowledge@Wharton: Can you think of a real-worldexample where volatile prices have led to some kind

of friction in a relationship, and how it was resolved?



16

Tevelson: Actually, I can think of a couple. The one

I like the best was in the appliance industry and

it was around the supply of some critical metals.

There was a longstanding relationship in place and

people were happy, in terms of the buyer side, with

the ability to buy at a fairly low price historically.

Then when the markets got tighter, things seemed

to change. The partners were both happy, but when

there was an opportunity to share what became a

scarce capacity with other buyers who were willing

to pay a bigger price, a conflict ensued.

You have a longstanding relationship focused on

quality, service and delivery undermined because,

on the margin, there was opportunism, and the rela-

tionship fell apart quite a bit, actually.

Knowledge@Wharton:Is that the exception ratherthan the rule these days?

Tevelson: I think in many cases the price-volatility

issue, which is really topical at the moment, is

addressed through transparency, so the commoditynature typically cant be influenced by both parties.

Theres an index and the price floats to that. And

where theres a reasonable way of resetting the

price based on an objective measure, the parties

can work together and not be arguing over

something they cant control. v



Multinational corporations have beensourcing from China for years, but that doesnt

mean that all the questions have been answered

about how to engage in procurement activities

in the worlds fastest-growing economy. In this

interview, David Lee, a partner and managing

director at BCG, says that plenty of challenges

remain. Among them: finding good suppliers that

offer products at relatively low costs, and being

willing and able to outsource a sufficient volume of

ones business to Chinese suppliers.

Knowledge@Wharton:Wed like to talk to you

a little today about China sourcing. As you well

know, thats a very important and particular issue

of interest to companies around the world. Can you

begin by giving us an idea of how China sourcing

differs from sourcing in other parts of the world?

Lee:I think China sourcing, to a certain extent, isvery similar to a lot of the low-cost country sourcing

or overseas sourcing. There are some things that

are particularly different because China is still going

through a lot of transitioning right now. So, there

are a lot of issues that need to be addressed. For

example, Chinese suppliers do not always have the

same capabilities and the quality level can be highly

uneven.

But on top of that, we have a very non-transparent

supplier market. We dont have, for example, a lot of

the supplier databases that you would like to have

in the Western world. When they first come to China,

the first major problem a lot of companies face

is: Where do you find a good supplier? There are

definitely a lot of suppliers out there, but whether

you can find a good one will be a big question.

And, of course, China is going through a lot of

changes as we speak. Chinese culture, historically,

Sourcing from China

is slightly different from the Western world in terms

of language, in terms of culture, and in terms of

the business norm because we are still going from

a planned economy to a more open economy.

All of these things are changing. I think one of

the interesting things that a lot of Westerners willalways say is, When a supplier says yes, they dont

really mean yes. They are just very polite.

Knowledge@Wharton: A moment ago, you said

the lack of transparency can be a challenge for

companies that want to source in China. How do

organizations go about surmounting that challenge?

Lee:Ive personally done a lot of sourcing in theWest and also in China. In the West, things are

relatively easy in terms of identifying the supplier

market, so you can always go to some database and

download a list of suppliers that are capable.

In China, theres no such database. Everybody says

they have some database, but our experience has

been that most of the databases are about 50% wrong

and then another 10% to 20% are outdated. So, you

never really can find a very good supplier database.

When they first come to China,

the first major problem a lot ofcompanies face is: Where do you find

a good supplier?David Lee, partner and managing director

BCG



18

Often, you need to do a lot of legwork before you

can do the sourcing activities. This becomes very

dangerous and very difficult for a lot of people who

have no experience working in China. We have seen

in a number of companies, when they do China

sourcing, instead of casting a wide net to find the

right supplier, they usually follow whoever your

competitors are sourcing from and go find those

suppliers.

So, we see that the good are getting better

and the worst are still staying there without

being developed. We see that quite often in the

automotive sector. At the very beginning, five, six

or seven years ago, when foreigners started coming

to China to source, they all came to the same place.

They all sourced the same parts.

Nowadays, with the supply base getting much more

capable and the local demand getting higher, we

see suppliers being developed to a certain level that

some are actually supplying to Western companies

for future models, which is a new thing in China.

Knowledge@Wharton: If an organization is dis-

satisfied or unhappy with the results of their China

sourcing programs, what should they think about

doing to improve their results? And secondly,

is there any industry against which they can

benchmark best practices, to try to find a good

example to follow?

Lee:I think those are very interesting questions.First of all, when you say that a company is not

doing well in China sourcing, there are usuallytwo issues. Number one is they cant find good

suppliers that can supply them at a relatively

low cost. Number two is they cant move enough

volume over to China. I think that these two

things are usually interlinked, but they can also be

separate.

What we have seen is that China has a lot of good

suppliers that are capable. And in a recent survey

with a number of China sourcing office directors,

what we have seen is that the savings ranges from

10% to 60%. And on average usually it is about 20%

to 30% on most commodities. If it is less than 20%

then it usually doesnt really make sense for you to

source in China.

So, Chinese suppliers definitely do offer significant

savings potential. But when we talk to these

companies and ask, Why dont you source more

from China? the consensus is because our head-

quarters is not willing to send more volume. If you

use baseball terminology, the catcher is always

ready to catch but the pitcher is not ready to throw

the ball. These are some of the issues that we see

time and time again across all industries and across

all companies.

We think that these are the major issues. Of course,

if we talk to the R&D people, the engineering

people, [and] the quality people at their headquar-

ters, there are always reasons why they are not100% willing to move their product over there.

Extending the supply chains [and] the risk with

changing suppliers all of these are risks. But the

question of how much risk each company is willing

to take will determine how successful they are in

the China sourcing arena.

Knowledge@Wharton:Despite the challengesthat exist in China sourcing, I assume that you

would say its still well worth it for companies to

pursue China because they can really reduce their

procurement costs. Is that accurate?

Lee:I think that would be right. But I wouldprobably go a little further. If you dont go to China

and if you just stay with your incumbent suppliers,

your competitors will not stay with you. Your

competitors are going to move to China anyway.

So, What are you leaving on the table? would be

a question.

We already see that a lot of suppliers in China are

getting to a kind of scale that is unheard of in the

West. And they have the capability of eventually

migrating to overseas markets and start attackingyour home turf. So, having a China sourcing team

over there, number one, can help you close that

gap. Number two, it will also help you understand

the supplier market dynamics so you can plan

accordingly.

I think that recently BCG has worked with a number

of clients that are expressing concern about all

of these Chinese [and] Indians or, in the old

days, the low-cost-country suppliers that are

emerging very quickly and now they might be

changing the dynamics of the markets.

Knowledge@Wharton:You mentioned a moment

ago that of course you have a lot of experiences

that you can discuss regarding BCG clients. I know

that youre probably reluctant to identify them. But

can you think of an example of one of your clients

which is doing procurement very well in China?

And, perhaps you could give an illustration of why

they are doing so well and what kind of steps they

have taken in that area?



Lee:I can think of one very recent example. Anautomotive company came to China about five or

six years ago to set up their China sourcing office.

At the time, not that many people were thinking

about China. But over the years they have increased

their China sourcing volume substantially.

Its still relatively small around 5% to 10% of the

global total spent. But its substantially higher than

some of their competitors. How did they do it?When they came to China, instead of just looking

at the supply base, they knew very well that in

automotive, with the stringent requirements in

the West the PPAP, the APQP all these things

are pretty much a foreign language to a lot of the

Chinese suppliers.

As a result, theyve developed a huge supply

development team focused on helping suppliers

get up to the companys standard and also up to

the automotive standard. Through this process, they

were able to develop suppliers that are much more

loyal to them. Number two is that they are able to

work with suppliers that are not locked in by their

competitors because they were not the first one to

move to China in terms of the automotive sector.

By doing so, they have created a supply base that

over the years has blossomed quite substantially.

And after five or six years, they are sourcing up to

5% to 10% of their volume from China. This is quite

substantial for automotive companies, given the JIT

requirements that you cant source everything from

overseas. So, I think that this company basically

entered into this particular angle by leveragingsupplier development.

Knowledge@Wharton: What sorts of benefits has this

company particularly seen from its efforts in China?

Can you tell us how much theyve saved in terms of

costs and other things that theyve achieved?

Lee:Well, I think there have been substantial costsavings. And of course in the automotive area,

what we have seen quite generally [is that] in most

of the companies coming over to China to source

automotive parts, in terms of casting toolings, they

can save up to 40% to 60% from the cost that they

would have paid if they were made in the U.S. or in

Western Europe.

If you are talking about harnesses, if you are talking

about aluminum wheels some of these products

range from the low teens to about 30%. So a wide

range of products really depends on what kind of

products you want to source and how well youre

sourcing.

Knowledge@Wharton:What are some of the mis-conceptions about sourcing in China that companies

might have before they embark on that kind of an

endeavor or when they are just getting into it?

Lee: I think that the one major misconception is:

Well, we need to go to China. Lets build a China

sourcing office and once you finish cutting the

ribbon, that everything [will be] business as usual.

We have seen quite a number of cases in a lot ofWestern companies when they come to China that

way.

Yes, of course you will always save money from

China. You will always increase maybe 10% to 20%

annually. We have seen a lot of the good companies

doubling every two to three years in terms of their

China sourcing volume. Given that you are starting

from a very, very small percentage of turnover

being sourced from China, unless you have quite a

substantial increase in volume like this, you will not

have a major impact in your organization.

I always work with our clients to give them an

estimate. Usually it would take you years just to get

10% of your volume sourced from China. You are

talking about, on average, saving about 20%. So that

is probably about 2% impact on your EBIT. This is

quite substantial, but it takes years for you to obtain.

The question for a lot of companies is, How can

I go beyond 10%? How can I go to 20% or 30%?

This will require a lot of commitment, not only

from the CEO, but all the way to the operating-level

people. A lot of the disconnect we have seen in thepast is that the CEO will tell Wall Street about one

thing, and then the operating-level people have no

idea how he came up with all these targets. And

as a result of this, they gave up. We have seen that

happen all the time.

Knowledge@Wharton: Is there anything else that

you would like to talk about to give our listeners

an idea of what the current hot issues are in terms

of sourcing and what the next couple of years are

likely to look like in the area of procurement?

Lee:Well, I think the major issue that we have seenin the past and probably will [see] in the near

future [is] convincing headquarters or convincing

your technical team that China is a viable source. I

think a lot of companies have found different ways

to achieve that. Definitely, there are a lot of internal

marketing tools that the China sourcing team

leader is implementing in China, and [is] actually

going back to the U.S. and to Europe to do a lot of



20

marketing or a road show to tell everybody how

great Chinese suppliers are.

We have seen some companies doing what they

call China Supply Day. They fly a lot of their

executives, including the quality people [and] the

engineering people, to China to look at all these

suppliers and have a sourcing conference in China.

One company has flown in about 70 people from all

over the world to meet with 200 selected suppliers.

And through this week of meetings, they have

arranged about 400 face-to-face meetings, one

on one, with some of these suppliers. As a result

of these activities, they were able to increase the

amount of sourcing.

I think given that Im based in China right now, a

lot of things dont really surprise me anymore in

China. But I remember when I was still working in

the U.S. that a lot of the image of China was very

backward [that it was] not very automated, that

machinery was rare, and that you basically have alot of sweat-shop work. And I think this is far from

the truth right now.

A lot of suppliers are extremely capable, highly

automated, and as a result, by bringing a lot of the

decision-makers to China to see for themselves,

it actually opened their eyes and changed the

perception. You cannot underestimate the impact of

changing the nonbelievers [and] the impact of that

on the entire organization. And by changing their

attitude, the entire organization will start moving

toward the right direction. v



Marshall W. Meyer, professor ofmanagement at Wharton, has made many trips to

China to research the rapid growth of its economy

and the successes and difficulties it has had

in growing so quickly. In this interview, Meyer

discusses the recent controversy surrounding

Chinas exports of substandard toys and pharma-

ceuticals to the United States, and the implications

for supply-chain management.

Knowledge@Wharton:As you know, theres beenno shortage of press reports in recent months about

the questionable quality of many of the products

that are coming out of China. What is your take on

this issue? How serious a problem is this?

Meyer:Any time a product poses risks to childrenand poses risks to people who are seeking medicaltreatment its a serious problem. So the magnitude

of the problem may be limited, but still I think we

have to take all of these issues quite seriously.

Knowledge@Wharton: In your view do the press

reports that we have been seeing on Chinas

products parallel in any way the products that were

produced, say, by Japan back in the 1950s when it

was emerging from World War II and trying to get

its economy going. Are there historical parallels to

these issues with China?

Meyer: There are and there arent. The parallel isthis: If you look at Japan prior to the 1960s or Korea

prior to the 1980s, a lot of the products they were

producing were inexpensive products. People would

sometimes joke about them. I dont think that the

products coming out of Japan and Korea at those

times posed threats to kids, but my memory could

be wrong on this.

Subcontracting and Product Quality in China

I do have a distinct recollection, however, from

the early 1970s when model railroad shops were

retailing some HO trains from Korea [that] were

marketed as the disaster series. They were so bad

that they were a joke. But of course, things have

changed very, very rapidly for Japan and for Korea.

Knowledge@Wharton: And in the case of China,

would you say that the experience of these shoddy

products, for lack of a better word, has been

limited? Is there something inherent in manu-

facturing systems in that country or in the way

that companies in China approach manufacturing

that has led to these kinds of problems? Is there

anything inherently awry in China that would cause

this kind of thing?

Meyer: I dont know if its inherently awry in China,

but I think there are some differences between

Chinese and U.S. systems that U.S. firms and U.S.

distributors dont fully appreciate. Let me start with

an example close to home. Weve all been reading

about the Boeing 787, and as of this morning,

Boeing promises that the Dreamlinerwill be

delivered on time.

Any time a product poses risks to

children and poses risks to people

who are seeking medical treatment,

its a serious problem.Marshall W. Meyer, professor of

management, Wharton



22

Still, they have encountered some difficulties in

meeting schedules. And what you read suggests

that their very lengthy supply chain is getting in

their way. There are countless

procurement management report

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